Key Factors Driving Rite Aid’s $2.60 Price Estimate

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RAD: Rite Aid logo
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Rite Aid

With 4,615 stores in 31 states across the country, Rite Aid (NYSE: RAD) is the third largest drugstore chain in the U.S. in terms of revenue and number of stores. It sells both prescription and non-prescription drugs as well as other retail merchandise such as cosmetics, household items, convenience foods, etc.

The rate of pharmacy sales growth in the U.S. has slowed down in recent years due to a decline in new blockbuster drugs, a longer FDA approval process, drug safety concerns and the loss of individual health insurance with the rise of unemployment. Additionally, the declining store count and rising proportion of generic (non-branded) drugs, which are priced lower compared to branded drugs have put pressure on Rite Aid’s top line. However, Rite Aid’s continued efforts to revive profits resulted in net income of $118 million, its first profitable year in five years, and the positive trend continued in Q1 2013. (Read: Rite Aid Continues Its Profitability Improvements Amid Declining Revenues)

The aging U.S. population combined with the fact that older people contribute to a larger proportion of expenditure on drugs, increased life expectancy, new drug therapies and the Affordable Care Act expanding insurance to millions of Americans are key trends driving growth in the pharmaceutical industry.

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With its store modelling initiative, the closure of underperforming stores, an expanding member base for its Wellness+ card-based loyalty program and its strategic alliance with GNC, we think that Rite Aid can benefit from the above trends. However, we believe that we have adequately accounted for the upside in our price estimate of $2.58 for Rite Aid.

In this article we discuss key segments and drivers that make up Rite Aid’s business.

View our detailed analysis for Rite Aid

Targeting individuals throughout the U.S., Rite Aid competes with other pharmacies including Walgreen (NYSE:WAG), CVS Caremark (NYSE: CVS) and the Wal-Mart pharmacy. Rite Aid earned over $25 billion in revenues in 2012 and made a 29% and 8.5% (excluding non cash expenses) gross profit and operating profit on the same, respectively. We expect operating margins to remain at the current level for the rest of our review period. While cost savings, restructuring initiatives and the higher proportion of high margin generic drugs will improve margins, the lower cost of generic drugs and the possibility of lower reimbursements for drugs by Medicaid and Medicare Plan D can restrict margin growth.

In 2012, Rite Aid spent approximately 15% and 30% of its operating profit as capital expenditure and selling, general and administrative expenses, respectively. We expect capital expenditure as a percentage of operating profit to continue rising on account of increasing investment for the Wellness+ program, more capital being allocated to purchase prescription files and investments in inventory management. Additionally, since the retail drugstore industry is highly competitive, we expect Rite Aid’s marketing expenses to remain high.

Rite Aid’s business can be broken down into the following categories:

1. Prescription Drugs – Rite Aid sells prescription drugs through its network of drugstores, specialty pharmacies and mail service facilities. The company derives 68% of its revenue from the sale of prescription drugs. In 2012, a total of 3.76 billion prescriptions were filed in the U.S. and Rite Aid accounted for 8.1% of the sales.

Total prescription revenue earned by U.S. drugstores are expected to reach $350 billion by the end of 2015, growing at 5.3% annually. [1] The U.S. Census Bureau projects that within the next two decades, the proportion of total population over 65 years will increase from 13% to 19%, whereas those between 20 years and 65 years of age will decline from 60% to 55%. An aging population will lead to an increase in the prescription drugs market. Additionally, the increasing government expenditures on healthcare is expected to drive drug sales. The 2010 U.S. health reform legislation is expected to extend health coverage to more than 30 million uninsured Americans.

Ride Aid’s increasing investment in the purchase of prescription drugs and the rising popularity of its Wellness + card based loyalty program can help the company gain market share in the future. The amount of capital it allocated to the purchase of prescription files has risen from $24.2 million in 2011 to $75.0 million in 2012, and the upward trend is expected to continue in the future. On the flip side, the closure of underperforming stores and intense competition in the market can restrict Rite Aid’s growth.

Currently, Rite Aid earns $56 in revenue per retail prescription. Going forward, we estimate revenue per retail prescription filled by the company to decline for a couple of years as sales of lower priced generic drugs increase with the expiration of patents for a large number of higher priced branded drugs. However, with the launch of new treatments and drugs, the situation could improve post 2015. In 2012, the company reported the generic penetration to have crossed the 80% threshold in November, and this is expected to increase further over the next few quarters.

2. OTC Drugs & General Merchandise: Rite Aid sells an assortment of general merchandise for household use along with over-the-counter drugs through its network of drugstores. It earns 32% of its revenue from this division.

The number of Rite Aid stores declined from over 5,000 in 2008 to 4,615 as of Q1 2013. The average store square footage has remained at 12,500 for the past few years. Going forward, we expect the number of stores to decline in the near term as Rite Aid continues to evaluate and close non-performing stores.

Rite Aid’s average revenue per square foot per store is approximately $142. We expect this to grow in the future on account of the expansion of the Wellness+ card based loyalty program, closure of underperforming stores, remodeling stores, expansion of immunization services and rising penetration of private brands. Rite Aid has remodeled  approximately 800 stores to its new Wellness Format in 2012 and targets remodeling of its entire chain over the next 5 years.

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Notes:
  1. New Study Predicts $350 Billion U.S. Pharmacy Industry by 2015, Identifies Risks to Profitability, Pembroke Consulting, July 30, 2013 []